What does theta measure?
Theta is the rate of decay of an option's price, all else held equal (including the fluctation in stock price and volatility). As you may recall from the Extrinsic Value post, the extrinsic value of a stock is determined by time and volatility. Theta measures how the rate at which the time value of an option price changes (or the time value aspect of the option's extrinsic value).
Theta in Conjunction with Buying and Selling Options
Sellers love theta. When selling options, as we've established, sellers sell premium to the buyers for the right to buy stock for the strike price at or before expiration. As time progresses throughout the duration of the contract, the extrinsic value, and therefore time value, of the option decreases. The seller can now profit by buying an option, with a now lower option price as a result of time decay ("Sell high, buy low"). The opposite is true for buyers, will are at a disadvantage as a result of time decay.
ATM, OTM, and ITM
The value of an option is always highest for ATM options, because here there is the most extrinsic value (0 intrinsic value). The curve of option prices slopes downwards as the underlying price goes further ITM and OTM because here there is more intrinsic value than extrinsic value. How does this principle relate to theta?
Because ATM options only have extrinsic value, theta decay increases faster than OTM/ITM options. When ITM or OTM, there is more intrinsic value, so there is not much left for the extrinsic to deecay by expiration. Contrastringly, when ATM, there is only extrinsic value so the option's theta decreases rapidly.
How can we apply this? Example:
If we know that theta decays rapidly for ATM options, we can sell an ATM options in order to buy back the option for an even lower premium and profit!
Eighteen-year old trader, future connoisseur of options.
Follow me on Twitter!